We remain positive on risk assets as we look forward into 2022 for the following reasons:
• Leading economic growth indicators remain robust.
• Consumer balance sheets are healthy supporting demand.
• Corporations are supported by favourable financial conditions with many currently able to absorb higher input costs.
• Evidence that supply chain bottlenecks may be starting to ease.
• In addition, increasing vaccination rates are supportive of the overall growth picture.
We recognise, that there are risks to our thesis as we pass an inflection point in monetary policy and face immediate headwinds of higher inflation and regulatory development within China. Although vaccination rates have improved, the Omicron variant is providing uncertainty. We, therefore, believe it is prudent to not tilt significantly towards one style.
The inflation outlook continues to dominate discussion. The recent UK CPI print came in at 4.2% year-on-year in October, the highest rate in a decade and above consensus expectations of 3.9%. The main factors contributing to higher inflation on a global basis are higher energy costs and supply unable to keep up with demand leading to bottlenecks. Our base case is inflation will peak in the first half of 2022 and will start to moderate as supply challenges ease but will sit at the higher end of central bank targets (2-3%).
Although higher energy prices present a risk to demand, in the US energy represents a smaller proportion of an individual’s income than in the past. Therefore the impact on consumption is not as prominent.
Wage growth is an important factor to monitor. There are currently 4m fewer people available to work in the US and 1m in the UK compared to pre-pandemic with individuals taking early retirement or unable to work lacking childcare. Should this situation not improve then wages will need to respond.
Consumer balance sheets are healthy, allowing them to absorb higher prices and the appetite to consume remains robust. For corporations, this is beneficial, as they are better placed to pass on higher input costs. This is evident in their reported earnings. The Q3 earnings season in the US was generally strong for many companies, with 66% of companies beating expectations so far. More companies are discussing supply chain challenges in their earnings calls and announcements. We are hearing tentative improvements, for example Ford, reporting better availability of semiconductors.
Growth expectations remain firm for the coming years. We are currently seeing softer economic data given supply issues but anticipate growth will return to firm levels towards the end of H1 2022 offering an opportunity for economically sensitive assets. We are therefore happy to maintain our exposure to cyclical assets.
We have passed an important inflection point. Central banks are on the journey of transitioning from their ultra-accommodative stance. The US will shortly begin tapering the pace of its asset purchases. On a monthly basis, the reduction will see $10 billion less in Treasuries and $5 billion less in mortgage-backed securities. This was well communicated and expected by investors. The Bank of England’s MPC was expected to raise interest rates at its November meeting but ultimately held leading investors to pare back interest rate expectations leading to volatility in both Gilts and Sterling. The ECB remains supportive with little expectation for interest rate increases. On a different tack, the PBoC have reversed into accommodative mode.
Equity markets have generally been well behaved but fixed income has experienced significant volatility with the MOVE, Merrill Lynch Option Volatility Estimate, index rising to its highest level since Q1 2020. Equities have been driven by strong corporate earnings, but government bonds have struggled with investors nervous that higher inflation will mean that central banks will tighten faster than expected. Within fixed income, we remain underweight, nervous of higher inflation and the potential for higher yields. We favour a shorter duration positioning, less sensitive to higher rates, although still hold longer dated issues for risk mitigation purposes.
In terms of styles, should inflation moderate and economic growth remain strong, our base case, pro-cyclical assets are favoured. The True Potential Portfolio proposition has a natural style bias towards value, and we believe we are correctly positioned in this respect.
Conclusion
– We remain positive on risk assets – overweight equities
– Underweight bonds but look for alternative assets that can provide risk characteristics similar to fixed income. Prefer shorter duration fixed income.
– Hold different styles but moderately tilt to cyclical assets.
– Inflation will moderate from current high levels but will land above target.
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